What is passive investing?

And you aren’t alone. S&P Dow Jones Indices CEO told CNBC in 2021 they found that hands-off investors have saved close to $360 billion.

How does passive investing work?

Passive investing is an investment stragey where the investor doesn’t do a lot of fiddling with trades and they don’t go digging for diamonds in the rough; a set-it-and-forget-it strategy. An investor creates a diversified portfolio — usually imitating a stock market index, like the S&P 500 — and sit on it for the long haul.

The goal with passive investing is to match the market’s returns, not beat it. After all, the S&P 500 has provided an average annual return of about 10% over the past half century. That’s pretty impressive.

Passive vs. active investing

Passive investing

Since there’s so little trading involved, passive investing is a much easier way for beginners to invest. Yet there’s plenty of evidence that it’s also more profitable than active investing.

S&P Dow Jones Indices — the people who decide which companies go in the Dow Jones and S&P 500, among other things — estimates that passive investing has saved people $357 billion in management fees over the last 25 years.

And that’s only for assets linked to the S&P 500, 400 and 600 indices. There are plenty more out there.

All of those fees are supposed to bring active investors better performance — but the company says that over the past two decades, 94% of U.S. investment managers have failed to beat the S&P 500’s returns.

“As indexing has grown, investors have benefited substantially by saving on fees and avoiding underperformance,” Anu Ganti, S&P Dow Jones’ senior director of index investment strategy, wrote in a recent blog post.

Active investing

Active investing, on the other hand, is what many people think of when you talk about trading. It means you — or the people running your actively managed funds — are trying to make predictions in order to buy low, sell high and get the best return.

It’s a difficult job. It requires knowledge, skill, patience and a lot of work to try to beat the market. Plus, all of the trading involved can mean lots of fees, and if you’re getting experts to make the decisions, those people need to be paid.

Warren Buffett on passive investing

“I recommend the S&P 500 index fund and have for a long, long time to people,” Warren Buffett, one of the world’s most successful investors, said at the annual general meeting of his company Berkshire Hathaway in May.

Buffett has long pushed index funds as the best option for most investors — even his own family. He has instructed the trustee in charge of his estate to invest 90% of his cash into the S&P 500 on behalf of his wife when he dies.

The true cost of investing fees

The average expense ratio of actively managed equity mutual funds was 0.71%, according to a 2020 analysis from the Investment Company Institute. As for index funds? Their ratios fell to 0.06%.

It may not seem like a dramatic difference, but it can cost you a pretty penny over the years.

Say you took $20,000 and put half in an index fund with an annual fee of 0.06% and the other half in an actively managed fund where you’re charged 0.71%. Imagine they both end up returning the S&P 500’s annual average of 10%.